Survivorship bias is a cognitive bias that can impact investors, researchers, and statisticians. It happens when individuals focus on the entities that "survived" some process and inadvertently overlook those that did not due to their lack of visibility. In the context of investing, this can mean concentrating on successful funds or companies while ignoring the ones that failed. Such a perspective can create a skewed understanding of success rates, risks, and factors associated with success.
Why is Survivorship Bias Important for Investors?
Skewed Data and Misleading Statistics: If you base your investment decisions on the success stories alone, you could be making assumptions from an incomplete data set. The unseen failures might hold key lessons or cautions.
Overestimation of Returns: Ignoring funds or stocks that disappeared due to poor performance can lead to an overestimation of average returns.
Miscalculation of Risk: By focusing only on success stories, an investor might underestimate the risk involved in a particular investment category.
Examples of Survivorship Bias in Investing
Mutual Fund Performance: Let’s say you're researching the average 10-year returns of mutual funds in a particular category. If you only consider the funds that exist today, you might be ignoring a number of funds that performed poorly and were merged or liquidated during that period. This could give you an overly optimistic view of the category's performance.
Stock Market Success Stories: When people talk about legendary companies like Apple or Amazon, they often forget about the tech companies that didn't make it. For every Apple, there's a BlackBerry, Palm, or countless other companies that either went under or became far less relevant. Focusing solely on the big winners can mislead investors about the odds of picking a successful tech startup.
Historical Stock Index Returns: The companies listed on major stock indices like the S&P 500 or the FTSE 100 change over time. Poor performers are dropped and new companies are added. If we only consider the performance of the index based on its current constituents, we're not getting a full picture of its historical performance.
How to Mitigate Survivorship Bias in Your Investment Decisions
Broaden Your Research: When evaluating an investment, look at the broader category or sector, not just the standout successes.
Use Comprehensive Databases: If you're looking at mutual fund performances, for instance, choose databases that include both active and defunct funds.
Question Success Stories: For every success story, ask yourself: How many failed attempts were there? What were the circumstances that led to the success of this particular entity?
Acknowledge Uncertainty: Even with comprehensive data, there's inherent uncertainty in the world of investing. Always account for this in your risk assessment.
Seek Professional Guidance: A seasoned financial advisor can provide valuable insights and might be aware of pitfalls and biases that you haven’t considered.
Survivorship bias is a sneaky pitfall in the investment world. By only celebrating and analyzing successes, investors can develop a distorted view of reality. This can lead to misguided expectations, poor investment decisions, and unexpected risks. Being aware of this bias, questioning narratives, and making decisions based on comprehensive data can go a long way in making sound investment choices.